Telstra Under Threat From TPG

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TPG Telecom has thrown down the gauntlet to Australian mobile businesses, confirming its intentions to become the fourth operator.

-Brokers flag caution on expenditure outlook as mobile services are hungry for capital
-Concerns the roll-out will occur at the same time margins are being compressed by the NBN
-Likely to become much harder for Telstra to fill its NBN earnings gap
 

By Eva Brocklehurst

TPG Telecom ((TPM)) has thrown down the gauntlet to Australian mobile operators. The company has confirmed it intends to become the fourth mobile operator, with a $400m capital raising and expenditure of $1.9bn flagged for the next three years.

TPG has acquired two 10 MHz blocks in in the 700 MHz range and will roll out incrementally, starting with Canberra in 2018, covering 80% of the population by 2020. Strategically, the company's move makes sense to Morgans as it should enhance value, but in the short to medium term the company is facing challenges along with the sector in general.

The broker recommends investors remain Underweight on legacy/full-service telcos. Mobile services are hungry for capital and, Morgans notes, fourth players lost hundreds of millions of dollars prior to 2009 when they merged into what is now Vodafone Australia. The broker understands it is only been this year that Vodafone Australia generated positive free cash flow.

TPG may be different, as it already has an extensive fixed line business in Australia and a much lower cost base to clear, with an existing mobile business that currently re-sells Vodafone, while its subsidiary iiNet currently re-sells Optus. The assumption is that business can migrate most of the re-sell business across to its own network.

Nevertheless, Morgans observes the company's mobile subscribers have been in decline for a number of years and the company has acknowledged it needs to triple its mobile customer base to achieve break even on operating earnings (EBITDA). This may also help fill the company's NBN earnings hole, if it can dynamically shift fixed traffic onto the new fixed cost mobile network.

Planned expenditure is well below that of its competitors, Credit Suisse asserts, acknowledging the company does have existing fibre infrastructure it can utilise. The broker observes this is a low-cost strategy in terms of operating expenditure and the risk is high that the company will have to spend more than it currently plans.

The metrics of the roll-out also suggests to the broker the offering will be materially inferior to competitors. This is expected to limit its ability to attract and retain customers in a segment where network quality is important.

Morgan Stanley believes the Australian mobiles market presents a very significant opportunity. The broker estimates it is worth $16bn in revenues annually with an earnings profit pool of $6-8bn at margins of 40-50%. The market is highly competitive, with Telstra ((TLS)) holding a 49% share, Optus 31% and Vodafone 20%, but Morgan Stanley cites a number of precedents for successful new entrants in mobiles markets around the world and retains a Overweight rating.

Citi downgrades the stock to Neutral from Buy, believing the total cost of establishing the network is simply too high, as meaningful revenue growth is unlikely to flow until it is largely built. This will all occur at the same time as the margin is being compressed in the core broadband business while the NBN is built.

The broker expects the company will take an aggressive approach to pricing and follow the same strategy that was successful in fixed-line broadband. The broker expects very low prices and high data limits, with price the main driver of subscriber acquisition. The company is expected to initially offer its service for free and only move to charging customers once they reach a network threshold.

The broker's original thesis of rapidly expanding free cash flow has been pushed out by at least three more years and Citi believes the company is more likely to spend that cash on further expansion rather than returning it to shareholders.

Expenditure

Expenditure consists of $1.3bn for spectrum, which was just auctioned off by the Australian Communications and Media Authority, and $600m for a mobile network to reach 80% of the population. The $400m capital raising is a 1-for-11.13 entitlement offer at $5.25 per share. Major shareholders including Washington H Soul Pattinson ((SOL)) will cover 60% of the fresh equity.

Credit Suisse's initial estimates suggest net debt will increase to around $2.4bn at peak in FY20 and be close to the debt covenant level of 3.25 times operating earnings. The broker believes there is minimal head room should mobile capital expenditure or start-up losses end up being higher-than-expected and there is also no headroom to fund additional spectrum or capital expenditure for 5G.

While the numbers appear low, Citi believes this is sufficient as a start, as the company already has most of the backhaul in place. If successful in winning market share, capital expenditure requirement should ramp up in line with subscribers and TPG will need to continue adding cell sites and spectrum as existing operators do.

Network Requirements

The price paid for spectrum was higher than Morgan Stanley expected but the company now has the low-band spectrum needed to ensure a quality network. Backhaul fibre connections are also in hand, including the building of more dark fibre towards Vodafone's mobile base stations.

The third part of the requirement is mobile base stations and towers, which TPG does not have. Morgan Stanley suggest tower sites could be rented from Axicom, an independent tower operator in Australia, and/or could be rented from Vodafone.

As background, Telstra continues to own around 50% of the tower assets in Australia versus Axicom, at around 25%, Optus at 15% and Vodafone at 10%. The vast majority of the additional towers are in regional areas.

Telstra Perspective

For Telstra, the mobile network was supposed to be the main driver of earnings growth as it plans to offset the $2-3bn operating earnings gap caused by the transition to NBN. Brokers observe this goal is about to get much harder.

Citi suspects, while it will take time for TPG to build its new network, an early competitive response will be forthcoming as the three incumbents adjust pricing to maintain market share and it would only take a small movement in price from either Optus or Vodafone to push Telstra pricing to an unsustainable premium.

Macquarie also downgrades expectations for Telstra following this shift in the industry's dynamics. The broker assumes an incremental -2% revenue share loss by FY24, effectively 3-4 years after TPG completes its national roll out. In addition, the broker agrees the presence of a new operator will put pressure on prices and revenues more broadly.

Given additional earnings pressures, Macquarie envisages Telstra only sustaining of dividend of $0.26 per share on its revised outlook. The broker had previously cut the company's long-term dividend forecast to $0.28 from $0.31.

Ord Minnett takes a different view and does not believe the threat of a fourth mobile operator will be that competitive or disruptive, given TPG is spending only $600m for a "bare-bones" network.

The broker does not believe the sell off in Telstra shares is justified, suspecting trading is based on sentiment and fear rather than reality, nor that a sub-scale network will be able to attract the customers that are paying a premium for Telstra's network.

Ord Minnett pares back its optimism on the company's mobile revenue and assumes that stays flat until there is evidence otherwise, yet continues to believe a cut to the dividend is unnecessary.

Mobile Roaming

A decision by the Australian Competition and Consumer Commission on mobile roaming is expected shortly. If the service is regulated it would directly affect the premium that Telstra can command for its network and its coverage advantage over competitors, in Macquarie's opinion. This could lead to a further valuation impact of up to $0.35 per share.

Citi also believes mobile roaming may be a bigger issue. The broker believes a roaming declaration could have a similar impact to TPG's announcement as revenues and margins come under further pressure, with smaller competitors better able to compete in regional areas.

The consensus target for TPG on FNArena's database is $7.21, suggesting 8.3% upside to the last share price. Targets range from $5.19 (Morgans) to $10.00 (Morgan Stanley). There are two Buy recommendations, three Hold and three Sell.
 

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